Marginal Productivity Theory of Distribution

The marginal productivity theory of distribution is the general theory of distribution. The theory explains how prices of various factors of production are determined under conditions of perfect competition. It emphasizes that any variable factor must obtain a reward equal to its marginal product.

There is no fundamental difference between the mechanism of determination of factor prices and that of prices of commodities. Factor prices are determined in markets under the forces of supply and demand. But there is one difference. While the demand for commodities is direct demand, the demand for factors of production is derived demand. For example, there will be demand for workers engaged in construction industry (e.g. masons) only when there is demand for housing.

According to the marginal productivity theory of distribution, in a perfectly competitive market (for products and inputs), each factor will be paid a price equal to the value of its physical product. Though the theory is applicable to all factors of production, we may illustrate it with reference to labour.

A firm will go on employing more and more units of a factor until the price of that factor is equal to the value of the marginal product. In other words, each factor will be rewarded according to its marginal productivity. The marginal productivity is equal to the value of the additional product which an employer gets when he employs an additional unit of that factor. We assume that the supply of all other factors remain constant. We shall give a simple illustration of the marginal productivity theory of distribution by making use of labour.

The aim of a firm is maximization of profit. It will hire a factor as long as it adds more to total revenue than to total cost. Thus a firm will hire a factor upto the point at which the marginal unit contributes as much to total cost as to total revenue because total profit cannot be further increased.

The condition of equilibrium in the labour market is

MCL = VMPL

Where MCL = Marginal cost of labour

VMPL = Value of marginal product of labour.

Or W = VMPL

Where W = wages of labour

Note : It is assumed that a firm can employ any amount of labour under a given wage rate as the supply of labour is assumed to be unlimited in a competitive market.

Note : P (The price is assumed to be constant under conditions of perfect competition)

In figure (b), the equilibrium of the firm is shown by E. This is so because to the left of L, each unit of labour costs less than the value of its product (VMPL > W). Hence the firm will make more profit by hiring more workers. To the right of VMPL

Thus the productivity of the marginal unit of a factor determines the rate that is to be paid to all units of the factor. The employer adopts the principle of substitution and combines land, labour and capital in such a way that the cost of production is minimum. Then the reward for each factor is determined by its marginal productivity. The marginal productivity theory of distribution has been used to explain the determination of rent, wages, interest and profits. That is why, it is called general theory of distribution.

Assumptions of the theory

The marginal productivity theory is based on the following assumptions.

1. There is perfect competition.

2. All units of a factor are homogeneous. It means that one unit of a factor is the same as the other.

3. Factors can be substituted for each other. That is, all factors are interchangeable.

4. The theory is based on the law of diminishing returns as applied to business. The law of diminishing returns tells that if you go on employing more and more units of a factor, its marginal returns will diminish. So a firm, when it comes to know that the increase in a certain factor is resulting in diminishing returns, the firm will substitute it with some other factor. There by, it will try to reduce the cost of production.

Criticism of the theory - The following are some of the points of criticism against the marginal productivity theory of distribution.

1. Every product is a joint product and its value cannot be separately attributed to either labour or capital. Again, it is rather difficult to measure the “productivity” of certain categories of labour like doctors, lawyers and teachers who render services.

2. The theory takes into account only the factors operating on the side of demand by ignoring the supply side. For example, when there is scarcity of a factor, it is paid much more than the normal price.

3. The theory is based on the assumption of perfect competition and full employment. But in the real world, we have only imperfect competition; we do not have perfect competition.

4. In practice, it is rather difficult to vary the use of the factors of production.

5. The theory does not carry with it any ethical justification. If we accept the theory, it means that factors get the value of what they produce. For example, workers in a firm may get low wages not because their productivity is low but because there might be exploitation of labour. Hence we should not make use of this theory to justify the existing system of unequal distribution.

We may note that in spite of the above points of criticism against the theory, it explains the role of productivity in the determination of factor prices. In the words of Marshall, “the doctrine throws into clearlight one of the causes that govern wages”.

Rent - In ordinary language, “rent” refers to any periodic payment made for the use of a good. For example, when we live in someone’s house, we pay rent. This rent is contract payment. The contract rent includes besides the payment made for the use of land, interest on the capital invested in the house, wages and profit. But classical economists like Ricardo referred by “rent” to the payment made for the use of agricultural land. Rent arises because of the peculiar characteristics of land. The supply of land is inelastic and it differs in fertility. Rent arises because of differences in fertility. Those lands which are more fertile than others get rent.

The Ricardian theory of Rent - Ricardian theory of rent is one of the earliest theories of rent. It is named after Ricardo, a great classical economist of the 19th century. According to Ricardo, “rent is that portion of the produce of the earth which is paid to the land lord for the use of the original and indestructible powers of the soil”. So rent is payment made for the use of land for its original powers. Ricardo believed that rent arose on account of differences in the fertility of land. Only superior lands get rent. Rent is a differential surplus.

Rent may also arise on account of situational advantage. For example, some lands may be nearer to the market. The producer can save a lot of transport costs. Even if all lands are equally fertile, lands which enjoy situational advantage will earn rent.

Ricardo explained his theory by taking the example of colonization.If some people go and settle down in a place, first they will cultivate the best lands. If more people go and settle down, the demand for land will increase and they will cultivate the second-grade lands. The cost of production will go up. So the price of grain in the market must cover the cost of cultivation. In this case, the first grade land will get rent. After some time, if there is increase in population, even third grade lands will be cultivated. Now, even second grade lands will get rent and first grade lands will get more rent but the third grade land will not get rent. It is known as no - rent land. According to Ricardo, rent is price determined, that is, it is determined by price of the grains produced in the land. He also believed that rent is high because price is high and not the other way round. Ricardo came to the conclusion that rent did not enter price because there are some no - rent or marginal lands. As the produce of no-rent land gets a price, Ricardo argued that rent did not enter price.

In figure (c), grades of land are shown along the X axis and the output up the y – axis. The shaded area in the diagram indicates rent. In this case, grade I and grade II lands get rent. The grade III land will not get rent.

Figure (c)

Criticism of the Ricardian Theory of Rent - Ricardo tells that only the best lands are cultivated first. There is no historical proof for this.

1.According to Ricardo, land has “original and indestructible powers”. But the fertility of land may decline after some time because of continuous cultivation.

2. Ricardo believed that rent is peculiar to land alone. But many modern economists argue that the rent aspect can be seen in other factors like labour and capital. Rent arises when ever the supply ofa factor is inelastic in relation to the demand for it.

3. Ricardo is of the view that rent does not enter the price of the commodity produced in it. But rent enters the price from the point of view of a single firm.

4. Ricardian theory does not take note of scarcity rent.5. It is based on perfect competition. Only under perfect competition, there will be one price for a good. But in the real world, we have imperfect competition.

Though there are some criticisms against the Ricardian theory, we may note it tells that because of increasing pressure on land, we have to cultivate inferior lands.

Modern Theory of Rent - In the modern theory of rent, the term rent refers to “payments made for factors of production which are in imperfectly elastic supply”. By this definition, rent is applied to other factors like labour and capital. In other words, rent does not apply to land alone. Just as land differs infertility, men differ in their ability. For example, a surgeon with a rare skill may earn a lot of income. There is an element of rent in it. In fact, we have a theory of profits known as “Rent theory of profits”.

Marshall has introduced the concept of “Quasi-rent” with regard to machines and other man-made appliances. So the modern view is that rent can be applied to all factors of production. Whenever, the supply of a factor is inelastic in relation to the demand for it, rent arises.

To explain rent, modern economists also make use of the term transfer earnings. Transfer earnings refer to the amount that a factor could earn in its best paid alternative employment. It represents the opportunity cost of its present employment. Any payment in excess of this amount is a surplus above what is necessary to retain the factor in its best-paid employment and so is rent. Thus, any payment in excess of transfer earnings is economic rent. If a popular south Indian Cinema actor who is normally paid, say Rs. two crores, gets an offer to act in a Hindi film for Rs. three crores, his transfer earnings are Rs. two crores. Rs. one crore may be considered as economic rent for acting in the Hindi film. So the main point about the modern theory of rent is that rent is not peculiar to land alone. The rent aspect can be seen in other factor incomes as well.

Quasi-Rent - According to Marshall, ‘Quasi-rent is the income derived from machines and other appliances for production by man”.

There are some machines and other man-made appliances (e.g.boats) whose supply may be inelastic in the short run in relation to the demand for them. For example, when there is large increase in demand for fish during a season, the demand for boats will increase. But you cannot increase their supply over night. So they will earn some extrain come over and above the normal income they receive. This, Marshall calls Quasi-rent. Quasi-rent will disappear, when once the supply of boats increases.

Wages

Introduction - Wages are the reward for labour. There are two main kinds of wages. (1) money wages and (2) real wages. Money wages are also known as nominal wages. Real wages refer to the commodities and services which the money wages command. They depend mainly on the purchasing power of money, which in turn depends upon the price level. The standard of living of workers in a country depends upon the real wages. Further, a farm worker may get low money wages. But if he gets free board and lodging, we must take that also into account while considering real wages.

Theories of wages - There are many theories of wages. Some of the early theories of wages are : 1. The Subsistence Theory of wages ; 2. The Standard of Living Theory ; 3. The Wages Fund Theory ; 4. The Residual Claimant Theory

Some of the important recent theories of wages are

1. The Marginal productivity theory of wages ;

2. The Market theory of wages and

3. The Bargaining theory of wages.

Early theories of wages

1.The subsistence theory of wages : According to this theory, the wages that are paid to a worker must be just enough to cover his bare needs of subsistence. If the workers are paid less than the subsistence wage, there will be starvation and death and it will result in shortage of supply of labour.

Criticism : The main criticism against the theory is that it is based on the assumption that an increase in wages will result in an increase in population. Man is different from an animal. Besides bare needs, he needs some comforts. This theory does not take note of that. And it is one sided. It ignores the forces operating on the side of demand. This theory is based on bad ethics.

2. The standard of living theory : This theory tells that wages dependup on the standard of living of workers.

Criticism : There is no doubt that the standard of living theory is an improvement on the subsistence theory. It is true that there is relationship between standard of living and wages. But it is rather difficult to say which is the cause and which is the result.

3. The Wages Fund Theory : According to Wages Fund Theory,“wages depend upon the proportion between population and capital”. The term “capital” in the context refers to the fund set apart for payment of wages. And the word ‘population’ refers to workers. If the supply of workers increases, wages will fall and vice versa.

Criticism : The theory assumes that an increase in wages will result in an increase in population. But there is no direct relationship between the two. Further, it tells that if wages rise, profits will fall. This is not correct because during periods of good trade, both wages and profits will rise.

4.The Residual Claimant Theory : According to this theory, wages “equal the whole product minus rent, interest and profits” (Walker). In other words, the theory tells that wages are paid out of the residue that is left over after making payment for rent, interest and profits.

Criticism : The main criticism against the theory is that it considers wages as residual payment. But wages are in the nature of advance payment and they have to be paid first. Normally, profits are taken at the end.

Recent Theories of wages

1. The Marginal productivity theory of wages : The marginal productivity theory of wages is only an application of the marginal productivity theory of distribution, which is a general theory of distribution. The theory explains how wages are determined underconditions of perfect competition. According to the marginal productivity theory, wages will be equal to the value of the marginal product of labour.

As an employer goes on employing more and more units of labour, its marginal product will fall because of the law of diminishing marginal returns. So he will employ labour upto the point where the wages he pays are equal to the value of the marginal product of labour. All units are assumed to be uniform. So the productivity of the marginal unit of labor determines the rate at which wages are to be paid to all units of labour.

Criticism :1. Every product is produced by the joint effort of all factors of production. It is rather difficult to measure the productivity of each factor in terms of the product produced. The difficulty is more in measuring the marginal productivity of those who render services (eg. doctors, actors and lawyers) ; 2. it is based on the assumption of perfect competition. But in the real world, we have only imperfect competition ; 3) under monopoly, wages will be lower than the marginal product of labour because there is exploitation of labour ; 4) wages are in the nature of advance payment. So an employer will deduct some amount to cover the interest on capital and pay the workers wages which are lower than their marginal product. So wages are the discounted marginal product of labour 5). The theory should not be used to justify the low wages in an economy and the inequalitites of incomes. Wages might be low because of exploitation of labour. Inspite of the above criticism, “the doctrine throws into clear light the action of one of the causes that govern wages”. (Marshall).

The Market Theory of Wages - The market theory looks at wages as the price of labour. Like all other prices, wages are determined by the market forces of supply and demand. The supply of labour generally refers to the total number of people available for employment. Some types of labour require long periods of training. During that long period, workers have to sacrifice their earnings. We have to take note of the foregone earnings while estimating the cost of labour which determines its supply.

The demand for labour - Demand for labour is a derived demand. Modern production is carried on largely on the basis of anticipation of demand for goods. During good trade, demand for labour will be more. Again, if capital is cheap, the employer will try to substitute capital for labour. When there is increase in investment, there will be increase in demand for labour. In a competitive labour market, equilibrium will be established at the wage that equates the demand for labour with the supply of labour.

Figure (d)

In figure (d), DL curve represents demand for labour and SL curve represents supply of labour. Demand for and supply of labour are presented along the X axis and wages are represented up the Y axis. Wages are determined (OW) at that point (E) where the demand for labour is equal to the supply of labour (ON) If demand for labour is high relative to its supply, wages will be high and vice versa. On the supply side, there are many imperfections.There is geographical immobility of labour. There may be shortage in the supply of certain categories of labour (eg. doctors, engineers). In some industries, the supply of labour is controlled by trade unions.

The Bargaining Theory of Wages - The bargaining theory of wages takes note of the influence of trade unions on wages through collective bargaining. According to the theory, the level of wages in an industry depends on the bargaining strength of the trade union concerned. The strength of a trade union depends upon many things like the size of its membership, the size of its “fighting fund”,and its ability to cause dislocation in the industry and the economy through strike. During periods of full employment and good trade, trade unions will be in a strong position and during depression marked by bad trade and mass unemployment, trade unions will be in a weak position.

A trade union may increase wages by restricting the supply of labour. For example, it may insist that only members of a trade union should be employed. This is known as closed shop policy. It may threaten that it will go on strike if a minimum wage is not paid.

Interest - Interest is the price paid for the use of capital. This is ‘net interest’ or ‘pure interest’. A good example of pure interest is the interest we get on some government securities. It may be regarded as net interest. Gross interest, includes besides net interest, other things such as reward for risk, remuneration for incovenience and payment for services. Thus gross interest covers trade risks and personal risks. For example, when a money lender lends money to an Indian farmer, he charges high rate of interest because there is the risk of non - payment of the amount borrowed. There are trade risks and personal risks. Generally, peoplep refer to have cash balances. This is known as liquidity preference. When you lend money to someone, you cannot get it for sometime. And that is incovenience. So to compensate it, one must be paid some extra income. So, gross interest includes compensation for all the above things besides net interest.

Theories of Interest - Some of the theories of interest are (1) The Abstinence or Waiting Theory of Interest ; 2. The Agio Theory and Time Preference Theory ;3. The Marginal Productivity Theory ; 4. Saving and Investment Theory (The classical theory) 5. Loanable Funds Theory and 6. The Liquidity Preference Theory

According to the Abstinence theory of Nassau Senior, interest is the reward for abstaining from the immediate consumption of wealth,. When people save, they abstain from present consumption. That involves some sacrifice. To make them save, interest is offered as a reward. But Marshall preferred the word, “waiting” to “absitinence”.

The “Agio” theory of interest of Bohm-Bawerk tells that as the present carries a premium (agio) over the future, and as people prefer present consumption to future consumption, we have to pay a price for them by way of compensation. And that is interest. The time preference theory of Irving Fisher is more or less the same as Agio theory of interest. The marginal productivity theory of distribution is nothing but the application of the marginal productivity theory of distribution. It tells that interest tends to equal the marginal productivity of capital.

The classical theory of interest tells that the rate of interest is determined by the supply of capital which depends upon savings and the demand for capital for investment. The theory is based on the assumption that there is a direct relationship between the rate of interest, savings and direct relationship between interest and investment. The classical economists believed that savings would increase when the interest rates were high, and investment would increase with a fall in interest rate. And the equilibrium between saving and investment was brought about by the rate of interest.

Loanable funds theory (Neo – classical theory) of Interest - The loanable funds theory was developed by Knut Wicksell, Dennis Robertson and others. The loanable funds theory is wider in its scope than the classical theory of interest. The term “loanable funds” includes not only saving out of current income but also bank credit, dishoarding and disinvestments. But by saving, the classical economists referred only to saving out of current income. We know now that bank credit is an important source of funds for investment.

In the classical theory, saving was demanded only for investment. But according to loanable funds theory, the demand for funds arose, not only for investment but also for hoarding wealth.

The classical theory regarded interest as a function of saving and investment, (r = f (S.I.) But, according to loanable funds theory, the rate of interest is a function of four variables, i.e r = f (1,S M.L.) wherer is the rate of interest, I = investment, S = saving, M = bank credit and L = desire to hoard or the desire for liquidity.

Figure (e)

In Figure (e) The Curve ‘S’ represents savings, the curve ‘M’ represents bank credit (including dishoarded and disinvested wealth). The curve S+ M represents total loanable funds at different rates of interest. On the demand side, the curve I represents demand for investment. The curve L represents demand for idle cash balances or to hoardmoney. The curve I + L represents the total demand for loanable funds at different rates of interest. The market rate of interest rm is determined by the intersection of S + M curve and I + L curve. The aggregate demand for loanable funds is equal to the aggregate supply of loanable funds at this rate of interest. In the classical theory, rn which may be called the natural rate of interest is determined by the intersection of Iand S curves. That is, when the rate of interest is rn, the demand for investment is equal to the supply of savings.

Criticism : There is no doubt that loanable funds theory is an improvement over the classical theory of interest. It has been criticized on the ground that it assumes that saving is a function of the rate of interest ; 2. it ignores the influence of the changes in the level of investment on employment, income and on savings.

Liquidity preference theory (Keynesian theory) of interest - Generally people prefer to hold a part of their assets in the form of cash. Cash is a liquid asset. According to Keynes, interest is the reward for parting with liquidity for a specified period of time. In other words, it is the reward for not hoarding.

According to Keynes, people have liquidity preference for three motives. They are 1. Transaction motive; 2. Precautionary motive; and 3. Speculative motive.

The transaction motive refers to the money held to finance day today spending. Precautionary money is held to meet an unforeseen expenditure.

Keynes defines speculative motive as “the object of securing profit from knowing better than the market what the future will bring forth.” Of the three motives, speculative motive is more important in determining the rate of interest. Keynes believed that the amount of money held for speculative motive would vary inversely with the rate of interest. Keynes was of the view that the rate of interest was determined by liquidity preference on the one hand and the supply of money on the other.

Figure (f)

In figure (f) Liquidity preference is shown by L and the supply of money is represented by M and the rate of interest is indicated by r. Rate of interest is determined by the intersection of L and M curves. There will be increase in the rate of interest to r1 , when there is increase in demand for money to L1 or by a decrease in the supply of money to M1.

Criticism : Keynesian theory is a general theory of interest and it is far superior to the earlier theories of interest. But critics say that Keynes has over - emphasized liquidity preference factor in the theory of interest. Moreover, only when a person has savings, the question of parting with liquidity arises. In the words of Jacob Viner, “without saving, there can be no liquidity to surrender. The rate of interest is the return for “saving without liquidity”.

Profits - Profits are the reward for organization or entrepreneurship. Risk-taking and uncertainty-bearing are the main functions of an entrepreneur. So we may consider profit as the reward for the above functions.

Gross Profit : Generally when we speak of profit, we refer to the difference between the total expenses of producing a good and the total revenue from it. But this is gross profit.

Gross Profit and Net Profit : Gross profit includes besides net profit other things such as the interest on capital, rent of land, wages of manangement and some extra income on account of the monopoly position of a firm. It also includes some chance gains (wind fall profits). While considering net profit ‘or’ pure profit, we have to deduct all the above things from gross profit. Net profit is the reward for risk - taking and uncertainty - bearing which are the main functions of an entrepreneur.The monopolist is the sole seller of a commodity for which there are no substitutes. As he controls the supply, it is possible for him to make huge profits. And this is known as monopoly profit.

Normal profit and super normal profit (excess profit) - Pure profit (net profit) can be divided into normal profit and supernormal profit. Normal profit is the minimum necessary to guarantee that an entrepreneur will continue to bear uncertainty and run the firm.That part of pure profit which is in excess of normal profit is excess or surplus profit or supernormal profit. Though firms under perfect competition may make surplus profits in the short run, it will disappear in the long run. Only a monopoly can earn excess profits indefinitely.

The early economists made no distinction between interest and profits because they considered the capitalist and the entrepreneur as one and the same person. The entrepreneur need not necessarily be the owner of capital. It is leadership rather than ownership that is importantin the case of an entrepreneur. Today, organization has become a distinct factor of production. Profits differ from other incomes in three ways. First, it is a residual income. Second, there may be wide fluctuations in profits and sometimes, they may be negative. That is, there may be losses. We cannot think of negative wages. Third, profits are uncertain.

Theories of Profit - Some of the important theories of profit are (1) the rent theory of profits (2) The marginal productivity theory of profits ; (3) The wages theory of profits ; (4) the dynamic theory of profits ; (5) the innovation theory of profits (6) the risk theory of profits, and (7) the uncertainty –bearing theory of profits.

Rent theory of profits

1. Prof walker is the author of the rent theory of profits. In his view, profits are the “rent of ability” and they are similar to rent. Rent arises because of differences in fertility of land. Similarly profits arise because of differences in ability. That is why it is called the “rent of ability”. The main criticism against this theory is that it explains only why there are differences in profits. It does not answer the fundamental question why there are profits as such.

2. The Marginal productivity theory of profits : The theory is an application of the general theory of distribution. According to this theory, under perfect competition, profits will be equal to the value of the marginal product of organization. We can apply all the criticisms against marginal productivity theory to this theory also.

3. The wages theory of Profits : According to Prof. Taussig, profits are not different from wages. Profits, are the wages of the entrepreneur for his special ability. Profits are the wages of management. The criticism against the theory is that we can speak of negative profits (losses) but we cannot speak of negative wages. Organization is a distinct factor of production. And it is different from labour.

4. The Dynamic Theory of profits: Prof. Clark is the author of thistheory. According to him, profits are the result of dynamic changes in society. Clark has defined profits as the excess of the prices of goods over their costs. Some of the important changes relate to the size of population, supply of capital, production techniques, industrial organization and human wants. Though the dynamic theory is one of the modern theories of profits, “it over looks the fundamental question of the difference between a change that is foreseen a reasonable time in advance and one that is unforeseen”.

5. Innovation theory of profits: According to Schumpeter, profits are the reward for innovations. An innovation is something more than an invention. An invention becomes an innovation only when it is applied to industrial processes. Innovation includes introduction of new goods, or new methods of production and opening new market. And innovations are introduced by the entrepreneur. Change and economic development take place because of his activities. So he gets profits for innovations. The criticism against the theory is that though innovation is an important factor in the emergence of profits, it cannot be the only factor. It ignores the risk-bearing function of the entrepreneur.

6. The Risk - bearing theory of profits :- According to Prof. Hawley, profits are the reward for an entrepreneur for risk- taking. Risk -taking is an important function of an entrepreneur. Risk-taking and profit-making go together. The main criticism against this theory is that it does not make distinction between known risks and unknown risks. Known risks (eg. theft, fire) can be insured against. We may say that profits are the reward for taking unknown risks. For there is a lot of uncertainty about such risks.

7. The uncertainity-bearing theory of profits : Professor Knight is the author of the uncertainty - bearing theory of profits. He is of the view that “profit is the reward not for risk - bearing but uncertainty- bearing”. His main point is that there is risk because future is uncertain. And uncertainty - bearing is an essential function of an entrepreneur.

The entrepreneur can insure known risks. But unknown risks (eg.competition risks, risks of government action) cannot be insured against. These risks are uncertain. The entrepreneur earns profits because uncertainties are borne by him. The criticism against the theory is that uncertainty - bearing alone is not the only function of an entrepreneur.

Conclusion : The main defect with all the above theories is that they stress only one or two functions of the entrepreneur. In addition to risk-taking and uncertainty-bearing, the entrepreneur performs a number of other functions. And he deserves reward in the form of profits.